Industrial revenue bonds include advantage of tax-free status

High wire or overland road?

Choosing investments - especially tax-free investments - sometimes seems like that kind of choice: Do you go for the highest possible return and take the risk that goes with it, or do you take the lower yields offered by the safer route?

To help resolve this quandary for some investors, two investment companies, Merrill Lynch, Pierce Fenner & Smith and the Fidelty Group, have been offering shares in a financing method known as industrial revenue bonds. Their returns are slightly higher than tax-free mutual funds, but the bonds are backed by irrevocable letters of credit from the issuing banks.

These tax-free investments are not actually mutual funds, but unit trusts. A mutual fund is generally open to new investors, or is open for a time, then closed. A mutual fund is also continually managed and the contents of the portfolio can change from time to time, even daily.

A unit trust has a specific number of units and is open to investors only so long as it takes to sell those units. Also, the portfolio is a fixed group of revenue bonds from a select list of banks. If Merrill Lynch or Fidelity want to buy bonds from additional banks, they open new trusts.

The trusts do resemble mutual funds, however, in that they pool money from a number of people to make investments.

Fidelity recently completed the sale of its first trust, selling some 7,900 units in its Floating Rate Series I. Each unit was worth $1,000 and the minimum investment was $5,000. A second trust will be offered in late September. Merrill Lynch's minimum is $1,000. Since October 1981 Merrill Lynch has placed 13 of the trusts, for sales of just under $500 million, a Merrill Lynch spokeswoman said.

Until a few years ago, explained Joseph T. Grause Jr., product manager for Fidelity's trust, industrial revenue bonds were issued only by commercial banks. If a firm wanted to build a new factory in a particular town, for instance, it could apply to a state or local development agency for status as an industrial-development project and could finance it through the sale of the revenue bonds.

If approved, the bonds would be issued by the bank at a lower rate than the company would pay even if it qualified for the prime interest rates banks offer their biggest and best customers.

This arrangement worked very nicely, Mr. Grause said, until banks started coming under ''earnings pressure.'' They weren't any happier having low-interest industrial revenue bonds on their books than they were with old, low-yielding home mortgages.

So Merrill Lynch, then Fidelity, figured they could help the banks get the bonds off their books and offer customers a piece of them, accompanied by a tax-free yield. The yield acutally ''floats,'' staying at 64 percent of the prime rate. So if the prime is at 13 1/2 percent, the trusts have a net yield of 8.7 percent; at a 13 percent prime, the yield would be 8.33 percent. While these yields are lower than standard money funds, they are tax-free.

This taxless feature, Mr. Grause says, makes the trusts most suitable for people in at least a 30 to 35 percent tax bracket. But with ''bracket creep'' pushing people into higher tax brackets, he points out, a 35 percent tax bracket isn't the big deal it used to be. Depending on their exemptions, a married couple filing jointly, for instance, could be earning less than $35,000 and still be ''wealthy enough'' to take advantage of this tax shelter.

Fidelity buys the industrial revenue bonds from about 60 banks, all of which carry at least an A rating from Standard & Poor, Mr. Grause said. (There are two higher ratings, AA and AAA, but A-rated bonds are considered investment grade.) Although Merrill Lynch and Fidelity are relieving the banks of the revenue bonds , the banks aren't completely off the hook; they have to issue a letter of credit that guarantees the bank's backing for the bonds.

Fidelity had to sell its first trust on its own, Mr. Grause said, sending letters and prospectuses to its customers who seemed likely prospects. Merrill Lynch has the advantage of a syndication arrangement with Dean Witter, Bache Halsey Stuart Shields Inc., and Shearson/American Express. Brokers for these firms - as well as Merrill Lynch brokers - can sell Merrill's Municipal Investment Trust Fund, Floating Rate Series.

Mr. Grause expects Fidelity will be able to use brokers to sell the second series of its tax-free trust